Tony Fratto: Lehman’s Lessons


They're really unanswerable questions, but they seem to be on everyone's minds this morning as we review the financial crisis that struck with such ferocity a year ago: Should the government have saved Lehman Brothers?

What would have happened if it did?

Former Treasury Assistant Secretary David Nason and I discussed these questions on CNBC's Squawk Box this morning.

In his New York Times column this weekend, Joe Noceraasserted that the Lehman failure was necessary because only the ensuing crisis could have altered the political landscape enough to get the Congress to pass $700 billion worth of financial rescue funds.

Nocera is right about the political environment.

Some forget that we were in the midst of presidential and congressional elections -- a time when it's hard to get votes to commemorate Mothers' Day, let alone the most unpopular, if necessary, piece of legislation ever to be brought before the Congress. And even with lending frozen, banks tottering, recession a certainty, breaking the buck in money markets, extreme volatility in equity markets -- the legislation actually failed in its first go-around in the House of Representatives. So, crisis was the 'Mother of Courage...eventually.

Lehman Brothers wasn't singled out for failure. It was merely the weakest limping bank at the back of the herd. For months Lehman's CEO, Dick Fuld, had been on the receiving end of lots of solicited and unsolicited advice to save the firm either by raising private capital or selling to a stronger firm. Lehman failed to raise capital and Fuld’s pride prevented Lehman from accepting any merger options.

By the time “Lehman weekend” rolled around, the situation was far more complex and potential solutions were scarce: AIG was about to implode; JPM Morgan Chase– a relatively strong bank – was trying to absorb both Bear Stearns and Washington Mutual; the government had already taken Fannie Mae and Freddie Mac into conservatorship. Merrill Lynch saw the writing on the wall and escaped to what then passed for a safe harbor in merging with a sickly Bank of America .

So, should we have saved Lehman?

Hank Paulson, then the Treasury Secretary, Fed Chairman Ben Bernanke, and then-New York Fed President Tim Geithner all say the question is moot: they simply lacked the tools and resources to rescue Lehman. Others argue that we could have and should have given the carnage that followed. I would argue that had we “rescued” Lehman, the political fallout would have been so great as to risk Congress statutorily prohibiting further rescues, which would certainly have been necessary.

“Saving” Lehman would at best have been a momentary pause in the storm.

In pre-TARP federal rescues, shareholders get wiped out.

That reality would have induced investors to flee other banks perceived as weak, thereby further weakening those institutions.

(This is one reason why relatively non-dilutive capital injections were ultimately successful.)

The Fed would have had to put the entire rescue effort – of Lehman and ensuing failures – on its balance sheet. Absent a stamp of approval from political leadership, this would have been untenable.

The most remarkable thing at the time of the Lehman bankruptcy was less that the government was unprepared with tools and resources to deal with a collapse. Rather, it was that the banks were themselves unprepared and largely blind to exactly what the fallout would be. Not a single bank had a full understanding of what their counterparty exposure was to Lehman going into that weekend -- even though Lehman had been listing for six months.

On the Saturday of Lehman weekend a friend at a Wall Street bank told me that said all the banks had fully staffed their back offices over the weekend, racing to determine their counterparty risk to Lehman. I was stunned. How could regulators know what the fallout would be for the sector if individual banks didn't even know what it would mean for themselves? Regulators will always have to depend on banks for that information.

Wall Street banks assumed that the federal government would come in at the last minute and either engineer or force an industry-led rescue (a la LTCM); a Bear Stearns-style unwinding; or a straight, taxpayer-financed bailout.

This is the very picture of “moral hazard’ that concerns many of us analyzing the lessons of the financial rescue, and it has implications financial regulatory reform going forward. Actually, it’s a moral hazard and a “Catch-22” all rolled into one.

Raising capital standards, restricting leverage, and improving management are all smart responses to the crisis. But in its regulatory reform proposal, the Obama Administration also intends to create explicit authority for the federal government to take over and unwind systemically important institutions like Lehman Brothers.

The Crisis: 1 Year Later - A CNBC Special Report - See Complete Coverage
The Crisis: 1 Year Later - A CNBC Special Report - See Complete Coverage

The moral hazard isn’t that banks take on excessive risk because they know the government will rescue them.

Ask a former Bear Stearns employee if they think they were “rescued.” No one would wish that kind of rescue on their worst enemy. Banks stretch the limits on risk-taking because of competitive pressures. Moral hazard comes into play only once a bank is clearly in trouble and close to failure: fearing a federal takeover, potential private sector investors stay away, further weakening the bank, and making failure more likely. However enticing it is to give federal authorities the tools and resources to unwind a failing institution in an orderly way in light of the Lehman fallout, the very existence of that authority at the point of crisis makes failure more likely. That’s the Catch-22.

At the end of the day, there are structural realities unique to regulated financial institutions that inescapably cause both practical and moral dilemmas for government, and that makes dealing with financial crises messy. But efforts to “prevent the next Lehman Brothers” could serve to make the next Lehman more, not less, likely. That would be the wrong lesson learned from Lehman.

On now:

Tony Fratto is a CNBC on-air contributor and most recently served as Deputy Assistant to the President and Deputy Press Secretary for the Bush Administration.